Foreign direct investment (FDI) is a major contributor to global macroeconomics accounting for US$1.35 trillion in 2012 (World Investment Report, 2013, p. 1). 2012 marks a historic year for FDI, as it was the first year ever that developing countries received more FDI, a total of 52 percent, than developed countries. Firms that engage in FDI are known as multi-national enterprises (MNEs). The question specifically focuses on the location factors of FDI; hence, only FDI inflows into the region of Latin America will be analyzed in the empirical section of this essay. FDI is a broad and widely accepted concept, it is for this very reason that it is difficult to find a precise definition in academic literature. The Organisation for Economic Co-Operation (OECD) has formalised a comprehensive definition of FDI describing it as reflecting the
“objective of establishing a lasting interest by a resident enterprise in one economy in an enterprise that is resident in an economy other than that of the direct investor” (2009, p.48).
The description then goes on to state that “lasting interest” implies a long-term relationship between the investor and the host country, that is created through direct or indirect ownership of ten percent or more of the voting power of a firm resident in one economy by an investor resident in another (OECD, 2009, p.48). The ten percent threshold was adopted as the OECD (2009, p.52) claims it shows evidence that the investor holds sufficient influence to have an effective input into the management of the direct investment enterprise. Firms that engage in FDI are known as multi-national enterprises (MNEs). The hypothesis for this essay; theories of FDI do not accurately predict what region firms will choose to locate their FDI. This essay will attempt to answer this hypothesis through an analysis of the empirical evidence and attempt to determine whether there is a definitive link between the theories of location factors of FDI and actual factors that determine the location of FDI in the region of Latin America.
Latin America is an intriguing region as it received significant investments in FDI prior to the debt crisis suffered by the region in 1982. Following the debt crisis, which was partly caused by closed economies and dictatorships the level of FDI into the region decreased due to both of these conditions. The region recovered remarkably well due in no small part to the influx of FDI into the region following more relaxed regulations on trade barriers by governments of the region. The region has a population of 500 million people and a GDP of an estimated US$3 trillion (Chen and Emile, 2013, p. 110) making it an obvious attractive location for firms seeking a large market for their products or low-cost of labour for the production of their products. Before beginning to explain and analyse the FDI theories of location factors a brief explanation of why firms engage in FDI is required. A firm chooses FDI over exporting their product if it will result in blocking competition in the host country more effectively.
The theory of FDI includes theories from both micro and macro-economics. The theories that predict where firms seeking to invest FDI will locate are the gravity theory of FDI, theory of market imperfections and the eclectic paradigm theory. Each of these theories will be discussed in detail below.
Gravity Approach to FDI.
The gravity approach to FDI considers the geographical, economic and cultural proximity and similarities of the home country and the host country. The theory predicts the closer the two countries are in proximity and similarities the higher the flows on FDI between the two economies will be. This theory explains the trade-off a firm faces between the cost of exporting and the cost of FDI (Nwaogu and Ryan, 2014, p. 1267). Trade-off is determined by relative market size of the parent and the host country, and distance between the parent and the host.
All firms desire a monopoly or oligopoly over the market as this enables them to earn supernormal profits. When home firms have a monopoly or oligopoly advantage over foreign firms they use FDI to exploit these advantages and gain market share. Firms that have a monopoly or oligopoly may choose FDI over exporting if FDI will enable it to block competition in the market of the host country more effectively. This theory has direct correlation between the policies of government in host countries and the extent of investment flows (Brewer, 1993, p.117). Countries under authoritarian regimes are more likely to facilitate the type of monopolistic and oligopolistic behaviour that certain MNEs engage in and hence, would be attracted to such countries (Hecock and Jepsen, 2014, p. 427). The level of democracy is a location factor of FDI, as authoritarian regimes potentially have the power to hold down wages, can resist pressure by local producers on subsidies and restrictions on MNEs (Hecock and Jepsen, 2014, p. 427). On the other hand democracies can be an attractive location for FDI as information moves much more freely providing firms with higher quality data on which to base their investment decisions. Hecock and Jepsen (2014, p. 428) also add that the representation afforded to MNEs in democracies may be more significant and attractive than that offered under a dictatorship. In simpler terms lobbying stable governments are preferable to MNEs compared to the inconsistency and illegality of corruption affiliated with authoritarian regimes (Hecock and Jepsen, 2014, p. 428). Due to the long standing time commitments associated with FDI MNEs will be more attracted to the stability of democracies and can be confident that deals made with democratic governments will be honoured into the future unlike the unpredictability of dictatorships (Hecock and Jepsen, 2014, p.428).
The Eclectic Paradigm.
This eclectic theory is the strongest theory for predicting the location determinants of FDI. This theory considers ownership advantages, location advantages and internalization advantages. As a result it provides a useful framework for categorizing many of the various factors that determine FDI. The application of the eclectic paradigm begins by a firm assessing its competitive ownership advantages relative to other firms in the market (Grosse, 2003, p. 59). The firm must then analysis whether it would be better for business to produce its products in an economy where it is already producing or whether it would be better to produce these outputs in a new country, this is the location advantage of the theory. Finally the firm must decide whether it would be more beneficial to produce its product itself, internalisation, or to contract some of the production process to be produced by a third party (Grosse, 2003, p. 59).
Ownership advantages therefore can be described as competitive or monopolistic advantages and must be sufficient enough to compensate for the initial costs of setting up and starting operations in a foreign economy, while also facing competition from indigenous producers (Dunning, 1988, p. 2). Ownership factors include the advantages of the proprietary ownership of specific assets in a foreign nation which are enjoyed by a branch plant of the firm and subsequent lower transactional costs resulting from the common governance of each branch firm located in various different countries (Dunning, 1988, p.2). Transactional market failure including, the safeguarding of supplies or to ensure the quality of the end product produced, is a major force behind MNEs seeking to exploit their competitiveness through ownership of assets rather than through contractual agreements with foreign firms (Dunning, 1988, p. 3). Contrasting to this argument is the higher the administrative costs and the external diseconomies or disbenefits of operating firms in a foreign country the more probable the firm will extend it’s international production through contractual agreements with firms based in the foreign economy rather than through ownership (Dunning, 1988, p. 3). The ownership advantages of assets extends to intangible assets such as a patent or trademark which are often exploited by a firm in a different country where these are easily recognized and sought after by the consumers of the country (Dunning, 1988, p. 4).
The most important strand of the eclectic paradigm for this essay is the locational advantages of the eclectic paradigm. This strand explains how MNEs will engage in foreign production whenever it is in their interests to amalgamate transferable intermediate products produced in their country of origin with some immobile factor endowments or other intermediate products in another country (Dunning, 1988, p. 4). The structure of the market is a key market imperfection that is likely to influence the locational decisions of MNEs. Such structural markets contortions include those arising from some kind of government intervention, which, will affect the cost and/or revenue of producing the product in different locations (Dunning, 1988, p. 4). Common governance of activities such as increased coordination of financial decision-making and the reduction of exchange risks in different locations often results in MNE activity occurring (Dunning, 1988, p. 4). In many situations the internalisation of the product produced by a firm is significantly intertwined with the ownership of the patent or technology needed to produce the product. This link often results in the firm deciding it would be more advantageous to continue production of the product itself to safe guard its technological knowledge of the product leading the firm to begin assessing where would be optimal to locate other production processes of the product. Although the locational factors of the eclectic paradigm is a separate category of the theory there is a relationship link between the ownership advantage.
It is important to note that in the original eclectic theory government regulation was not a factor of location advantages and was subsequently added by Dunning upon revision of the theory in the 1990s (Grosse, 2003, p. 61). Dunning recognized that his eclectic theory contained a flaw by not factoring in regulatory and the political environment of a region in the location advantages of a firm choosing where to locate its FDI (Grosse, 2003, p. 68). Dunning sought to remove this flaw with his work in the 1990s showing a clear emphasis on extending the theory to cover the area of government and business relations (Grosse, 2003, p. 58). This extension of the theory comes in under the location advantages category of the eclectic paradigm as which locations may be preferable due to economic cost basis as was originally set out along with the new feature of, on the basis of providing better regulatory treatment of the MNE (Grosse, 2003, p. 68). The economic factors that contribute to explaining location factors of FDI are well accentuated and easily interpreted through the eclectic theory. The difficulty in utilizing the theory to explain modern phenomena of modern business in Latin America has more to do with the dramatically changed political landscape and organizational issues of business that unfortunately fall outside the scope of the theory (Grosse, 2003, p. 68).
In essence the eclectic paradigm is an accumulation of the theories of market imperfection and gravity theory of FDI. A factor that determines the location of FDI not accounted for by the theories of FDI is the expected future profits of the firm. Each of the theories that will be discussed have deep interconnections in the empirical evidence presented by the academic research and at times all three are used to explain the location of FDI in the region.
Empirical Evidence Section.
The Economic Commission for Latin America and the Caribbean (ECLAC) (2014, p.11) lists a number of factors that attract FDI to recipient countries, these include, “the investment climate and risk, the legal and tax environment, economic performance, natural resource supply and the host country’s participation in free trade agreements.” Other factors not mentioned by the report would include the degree of unionization of workers, the protection of property rights and certain policies adopted by some governments including a requirement to transfer knowledge (Javorcik and Spatareanu, 2005, p. 384). According to the World Investment Report (2013), conducted by the United Nations the three basic sectors of production, natural resources, manufacturing and services sectors, received roughly the same amount of FDI in 2013. The sector receiving the highest proportion of FDI inflows with 38 percent was the services sector, followed by the manufacturing sector at 36 percent and finally the natural resources sector at 26 percent (ECLAC, 2014, p.10). The empirical evidence will be analyzed under the following headings; host country policies, economic environment, technology and firm strategy. These have been chosen as they all significantly contribute to the various factors considered by a firm choosing which location to locate its FDI.
FDI reached an all-time high in 2013 in Latin America with Brazil ranking as the highest receiver of FDI inflow in Latin America receiving US$64.046 billion (ECLAC, 2014, p.9). The empirical evidence collected by Grosse (2003, p. 62) shows the largest MNEs located in Latin America according to sales in the year 1999 were firms led by major oil and auto companies along with a number of infrastructure companies highlighting the fact that the region hosts firms from the three different production sectors, natural resources, manufacturing sector and the services sector. The firms in the group of largest MNEs in the region generally are producers of capital-intensive products (Grosse, 2003, p. 62).
Host Country Policies.
Host country policies vary greatly in the region due to the presence of established democracies, emerging democracies and dictatorships (Carrillo-Tudela and Carmen, 2004, p. 687). The presence of natural resources is also another notable factor that has a significant influence on the policies of Latin American countries. Investors can be described as having a natural tendency to concentrate on sectors in which the host country holds a comparative advantage (ECLAC, 2014, p. 25). The investment in local natural resources is explained by the eclectic theory as FDI in natural resource exploration and production, specifically in oil and metals as well as agricultural products such as fruits for example bananas (Grosse, 2003, p. 56). Although the manufacturing and natural resources sectors account for 62 per cent of the FDI in the region, it must be noted that since the 1990s the manufacturing sector has been more prominent in Mexico and some countries of Central America, which produce products for export to the United States (ECLAC, 2014, p. 25). FDI in natural resources was concentrated in the South American countries with the Plurinational State of Bolivia being the dominant receiver of FDI inflow in the natural resources sector (ECLAC, 2014, p. 26). Hydrocarbons and mining industries were the dominant natural resources receivers of FDI (ECLAC, 2014, p. 26). Some countries of Central America such as Panama and Guyana are only beginning to host large mining and hydrocarbon projects and it is expected that these economies are likely to become dependent on FDI in natural resources in the coming years (ECLAC, 2014, p. 26). However, the natural resources sector is suffering from decline due to the conditions mentioned above in some countries of the region.
Acquisitions to gain entry to new markets in the region is a trend that is continuing to grow in the beer, food, cement and chemical industries and are occurring in most countries of the region with Mexico being one of the more prominent countries (ECLAC, 2014, p. 27). These acquisitions are acquired to produce for the local market and form national oligopolies, these are then consolidated from a regional level to a global level through further acquisitions by foreign firms (ECLAC, 2014, p. 27). This is an example of the market imperfection theory in practice.
Latin America receives a modest amount of FDI in infrastructure in the services sector. With the exception of the telecoms and electricity sectors FDI in infrastructure development has been below what is desired by many governments of the region and it is for this reason that some governments are actively seeking FDI in infrastructure by creating environments conducive to FDI through new programmes and regulatory changes (ECLAC, 2014, p. 28). However, thus far investments are materializing only in certain segments of the region and in specific sectors, most notably airport management which saw Brazil privatize five large airports over the past two years, most of which went to international companies (ECLAC, 2014, p. 28).
Latin America during 1960-82 presented an era that was rather futile towards MNEs as the public and governments of the region found themselves caught up in a whirlwind of nationalism. This nationalism resulted in government policies excessively restrict MNE activity, from initial investment limits through prohibition of investment in some sectors all the way to limits on profit remittance and on other payments including royalties and interest on intra-company loans (Grosse, 2003, p. 56). It could be argued in this case that the location conditions as described in the eclectic theory did not favour direct investment in the region and that MNE production was best located in another region (Grosse, 2003, p. 56).
Finally, services for export that are not capital intensive and do not attract large inflows of FDI, such as business processing outsourcing, are becoming increasingly crucial for some small economies and been growing at a consistent rate in recent years (ECLAC, 2014, p. 28). These require a relatively skilled labour force and range from basic call centres to advanced operations such as medical, software and legal services (ECLAC, 2014, p. 28). Due to the large capacity to create jobs many Central American governments actively offer incentives for firms in this industry, through tax waivers or other forms for example the government of El Salvador offers English lessons to 650 people a year to enable them to become proficient enough in the language to work in call centres (ECLAC, 2014, p. 28).
According to the ECLAC (2014, p.21) one of the main factors driving the rise of FDI over the past decade in Latin America is economic growth along with high international demand for export products. Due to increased prices for metals and other minerals, FDI in the mining sector rose during the last decade in the Latin American countries of Chile, Peru, Colombia, Brazil and Mexico (ECLAC, 2014, p. 26). It must be noted that in 2013 this trend was beginning to reverse due to a drop in the price of metals and a substantial increase in extraction costs such as the cost of energy (ECLAC, 2014, p. 26). Latin America in the eras of 1945-60 and 1982-90, when low levels of regulation were witnessed saw the beginning of a surge in FDI into the region. Market-seeking MNEs originally entered the region through imports to serve the local markets in countries such as Mexico, Brazil and Argentina along with smaller economies of the region (Grosse, 2003, p. 56). These MNEs successfully incorporated the eclectic theory by obtaining ownership advantages such as proprietary technology and marketing skills (Grosse, 2003, p. 56). The MNE usually fully internalized production outside of the region except in the cases of low-value consumer goods and some other sectors of manufacturing such as autos that were required to include local content (Grosse, 2003, p. 56).
Due to the increasing importance of services globally it is not surprising that the services sector receives a large share of FDI in almost all economies of Latin America in contrast to natural resources and manufacturing determined by local needs and conditions (ECLAC, 2014, p. 25). The increase in the services sector in the last decade driven by growth in consumer spending can be attributed to the rise in incomes which led to millions of Latin Americans purchasing their first mobile phone, open their first bank account and begin to shop in supermarkets with many of these services being provided by transnational corporations (ECLAC, 2014, p. 28). As the region has had some regulatory and technological changes occur this has led to the opening of new areas of FDI. Renewable electricity generation is one such new technology that has increased FDI inflow into Latin America (ECLAC, 2014, p. 28).
Investors can be described as having a natural tendency to concentrate on sectors in which the host country has a comparative advantage (ECLAC, 2014, p. 25). FDI in natural resources was concentrated in the countries of South America who have a rich abundance of natural resources. Since the 1990s, FDI in the manufacturing sector has been more prominent in Mexico along with some countries of Central America, which are used as locations to produce goods for export to the United States (ECLAC, 2014, p. 25). This conforms to both the gravity theory of FDI and the internalisation theory through the commencement of the maquiladora plants in the region (Grosse, 2003, p. 58). The use of the maquiladora plants is most prominent in Mexico where MNEs have established both owned and licensed assembly operations to manufacture export goods such as clothing, autos and electrical products (Grosse, 2003, p. 58). Maquiladora plants represent a splitting of the production process to take advantage of both low cost labour in Mexico and Central America and the geographically proximity to the United States where the products will ultimately be sold to consumers (Grosse, 2003, p. 58). The measurements by the ECLAC (2014, p. 28) have shown that this type of FDI has remained stable over the past decade.
Nwaogu and Ryan (2014, p. 1268) state MNEs consider the factors of the gravity theory on countries of close geographical proximity to the host country when deciding where to invest their FDI. The US, a country very close in geographical proximity is Latin America’s largest investor of FDI totaling US$679.0 billion in 2009 (Nwaogu and Ryan, 2014, p.1268).
The decision of internalisation has become much more difficult in recent eras as business has moved to a greater focus being placed on networks of firms that both compete and cooperate with many even sharing partial ownership as well as some of their resources (Grosse, 2003, p. 64).
The evidence obtained by Grosse (2003, p. 64) suggests that the location factors for selecting the region of Latin America appear to be based more on the availability of raw materials or creating a local production presence than on any criterion of cost minimization as many of the companies that have located in the region have already achieved a low cost of production of their product.
The theories of FDI particularly the eclectic paradigm are relatively accurate in predicting the location of FDI as outlined above however, due to the variety of factors influencing the determinants of FDI there is no theory that conclusively incorporates each of the appropriate factors. A major draw back of the eclectic theory is that is specifically focuses on inter-company competition while unnecessarily does not place significant emphasis on the relations between MNEs and governments in the host region. It is a fundamental flaw of the eclectic paradigm as governments often intervene in the business environment of MNEs to set or change the regulations. This defect in the theory fails to explain MNE responses to governments policies following various economic conditions such as the debt crisis or an economic boom as the theory assumes the regulatory and macroeconomic conditions as given (Grosse, 2003, p. 57).
The academic literature often looses sight of the fact that each firm is unique and it is perhaps the wrong approach to find the aggregate of FDI flows and use that as the empirical evidence for analysis. These aggregates of FDI are an accumulation of individually made decisions by different firms that clearly consist of their own unique variables that are the real factors in determining where firms choose to locate. The future of academic research studying the relationship between location and FDI should focus more on individual firms rather than on calculating the aggregate of flows and deducting the factors of location, from what coincidently happens to be the factors of the region. It must be noted that this approach would be much harder to complete as it would be very costly and time consuming to approach individual firms to accumulate the necessary empirical evidence and it is probably for this reason that research with this approach has not be conducted previously as academics were satisfied to simply use aggregates of the FDI flows into a region.